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ECU's Investment Blog

"If you follow the trend you
will always be right behind it” Lindsey
Haun

On reflection, the month of February could be classified as
the calm after the storm of January. While there was much focus on the Greek
drama that played out in February, the broad markets remained sanguine about
the possibility of a resolution (even at the eleventh hour). Amid this,
volatility declined and, across the FX markets, currencies regained and
retained relatively narrow ranges. As is often the case in the global data
calendar, the first week of the month is action packed and as a result we expect
March to signal the return of volatility, acute focus and, in many cases, a
resumption of some core trends.

In the Eurozone, the data has shown some improvement of
late, as the fall in the oil price and renewed monetary commitment from the ECB
have underpinned sentiment at both the consumer and corporate level. However,
with the exception of Germany (who will likely continue to benefit
disproportionately from the monetary stance of the ECB), the continued fall in
prices (which have now fallen for the past three months) and still high rate of
unemployment confirm the continued headwinds to the economy and, with GDP
rising far too slowly to erode spare capacity in the economy, this weakness
likely persists.

This morning’s retail sales data from Germany highlights the
potential for growing economic divergence within the region, and the difficulties
ahead for the ECB, as this growth disparity potentially lays bare the
limitations of a one size fits all monetary policy for such a (socially,
politically and economically) diverse union.

Yesterday, saw the release of the February global
manufacturing PMI data. Across the Eurozone, the manufacturing recovery stalled
in February, despite a modest improvement in Germany. Perhaps most
disappointingly, Eurozone manufacturers failed to register a significant
improvement in export orders despite the recent fall in the EUR.

"Demand excellence” Emmitt
Smith

In the UK, by contrast, manufacturing expanded at its
fastest pace in seven months. There is some evidence that the weaker oil price
is boosting the domestic economy not just by boosting consumption in an economy
where domestic demand has remained
strong (unlike its Eurozone peers), but also by allowing firms to lower prices
and boost margins.

"I don’t measure America by its achievement but by its potential” Shirley Chisholm

Looking ahead this week, the US comes back into focus after
a relatively disappointing manufacturing PMI yesterday (though it is difficult
to strip out the impact of the recent port dispute on the final data).
Wednesday brings the release of the private sector (ADP) employment data which
will likely shape expectations for the all-important US employment report on
Friday. Wednesday also brings the release of the service sector PMI data, which
is more likely a clearer indicator of the strength and momentum of the US economy.
We would also expect the service sector data to highlight the strength of the
UK economic momentum, and perhaps even of an improved backdrop in Germany, but
the rest of the Eurozone’s activity likely remains moot.

On Thursday the Bank of England policy meeting is unlikely
to bring any announcement or statement, however, the ECB, while not announcing
any new measures will be keenly awaited for the release of further details
surrounding its imminent QE programme. The numbers involved in the QE target
purchases are very significant (a further reason why yields across the region are
otherwise unthinkably and universally low) and thus the way in which those
purchases are transacted in order to maintain purchase targets and to minimise
price distortion is key.

We will comment further on the US employment report later in
the week, suffice to say that we have little reason at this stage to suspect
any reversal of the recent strength in the labour markets, or indeed the USD.

"Prediction is very difficult, especially if it is about the future” Niels Bohr

We retain the view that the USD and GBP continue to
outperform in FX markets as their economic outperformance implies monetary
outperformance, supported by the global backstop of ECB (and BoJ) QE. The
extreme weather and the port dispute in the US add to the potential volatility
and uncertainty, likewise the forthcoming General Election in the UK could be a
potential banana skin.

In 2015, we continue to anticipate further gains in USD and
GBP vs. EUR (AUD and JPY). Economic and geopolitical events likely mean that
such a move will not be in a straight line. It is possible however, that this
means more opportunity for FX, not less

On Tuesday we
discussed our views of the progression of US monetary policy ahead of Fed Chair
Yellen’s semi-annual testimony to both House and Senate Banking Committees. We
stated clearly that we expect the term "patient”
to be removed from the statement in March to allow greater flexibility in
asking "why would the Fed wish to
constrain itself so as to not enable a first (baby) step towards the normalisation
of rates in June should it be warranted.”

Yellen effectively
backed this (likely last) iteration of forward guidance, yet maintained that
the removal of the term "patient” was
not a precursor to an incremental rate increase in two meetings time, more that
it would give the Fed the flexibility to make an assessment to normalise
monetary on a "meeting by meeting basis”
should it be warranted.

"Monetary policy must be forward looking” Janet
Yellen

Yellen noted that some
"foreign developments could pose a risk
to the US”, but that those risks were not just to the downside (perhaps a nod to the potential positive
implications of ECB QE). Her reference to the fact that the Fed expects
inflation to gradually rise to 2% and that the Fed will raise when they are "reasonably
confident” on inflation, was taken by some as a modestly dovish development. We
disagree.

Yellen also stated
that GDP is strong enough to further gradually lower the jobless rate, and in
the Q&A from the Senate, she was quick to defend the Fed’s medium term
price stability mandate over the political urge to keep rates low as long as
possible. In conjunction with her view (as per Carney) that low inflation in
the near term is transitory our view is that the Yellen testimony, Fed bias and
US economic momentum are all bullish and we continue to expect higher short
term US rates, and a higher USD. In our view, the signal from Yellen was
hawkish, yet the care with which the evolution of forward guidance was managed
means there is perhaps a small window before such bullishness becomes active!

"We are hearing the sound of transmission” Kraftwerk,
Radioland

In the UK, this
morning saw the confirmation of robust GDP growth with Q4 rising 0.5% q/q
(+2.7% y/y). The breakdown highlighted a slight underperformance of both
private consumption and government expenditure relative to expectations, while
exports sharply outperformed. The one real disappointment came alongside the
GDP report in the form of a contraction in business investment (the weakest reading
since Q2 2009), likely, at least in part, a function of the political
uncertainty around the upcoming elections.

Our view of the UK
and GBP is very similar to that of the US and USD, yet with greater uncertainty
due to the general election in just over 2 months’ time. Economic and monetary
outperformance remains key and while the negative impact of political
uncertainty likely become more acute over coming weeks, the potential for a
sharp upward revaluation of UK interest rate expectations and GBP should the
election pass without too much drama is, in our view, high.

"QE has high transmission potential to economy” Mario Draghi

Draghi was also on
the newswires yesterday as he gave testimony to the European Parliament. Apart
from the becoming visibly hot under the collar when heckled by the Greek
representative over the removal of Greek collateral eligibility, Draghi was
broadly upbeat. His message that monetary policy can provide the conditions for
growth but it cannot create growth by itself, was a clear reminder that the
central bank has (arguably belatedly) done all it can to stimulate growth, the
rest is up to the politicians, governments and countries themselves.

In the near term the
messages are mixed for the Eurozone, the anticipation of QE (and the sheer size
of purchases relative to the market) have ensured that yields across the Eurozone
have fallen dramatically. In fact, the 10 year debt of Ireland (still a
programme country) yields less than 1.0% and the German yield curve is now
negative beyond 7 years! Lower yields act to undermine the currency. Add to
that the increasing political disparity in the growth vs. structural reform
debate (not just in Greece, but France, Italy and Belgium) and the case for
weakness is compelling.

"And no-ones jamming their transmission” The Police; De do do do…

On the other hand, as
noted by Draghi yesterday, the sentiment and confidence in the Eurozone should
be given a decent boost by QE across the region and in addition to positive
growth surprises in Germany and others (notably Holland and Spain) in Q4, ECB growth
forecasts for 2015 are likely to be revised upwards over coming weeks.

For now that likely
supports continued range trading in FX, until the data gives the market cause to
break out.

Today’s main event
will be the Testimony of Fed Chair Janet Yellen to the Senate Banking Panel. As
regular readers will be well aware, our central expectation for Fed policy
remains that US monetary normalisation will begin (albeit at a very moderate pace) at the June meeting. In that
regard, the progression of the Fed communication policy or forward guidance
would likely require the removal of the term "patient” from the statement at the March 18th policy
meeting.

The broad market consensus
has become centred on the fact that with inflation at such low levels, and with
so many central banks around the world easing policy further, why would the Fed
raise rates. The consensus view is that the Fed can be patient in removing "patient” from the statement.

Our view is, in many
respects, the exact opposite. Fed forward guidance has evolved a long way over
recent years with the latest (and likely
the last) iteration being the term patient – explicitly defined as meaning
policy will likely not be tightened within the next two meetings. With US
employment having risen at a record pace and with the unemployment rate at 5.7%,
amid tentative signs that wages are picking up (something which likely accelerates as the unemployment rate approaches
its equilibrium level), why would the Fed wish to constrain themselves so
as to not enable a first (baby) step towards the normalisation of rates in June
should it be warranted.

"Convincing yourself does not win an argument” Robert
Half

The argument that
other central banks are easing is also not a convincing argument for us either.
In terms of US QE, the Fed would argue that it is the stock of assets that
provide the stimulus and not the rate of accumulation or purchase of those
assets. Accordingly, Fed policy is the most accommodative it has ever been at
this point. In our view, this is unsustainable in terms or economic momentum
and future (once the oil price drop base
effects drop out) inflation trajectories.

We do not, therefore,
see the removal of "patient” as
showing too little patience, as many have suggested. Rather, we would see its
removal as maintaining Fed policy flexibility, giving the Fed the option to initiate
the process of normalising rates it would not otherwise have.

In any event, Yellen
likely makes it clear that the pace of policy normalisation, once it does start,
will be slow and it will reach a much lower terminal rate than historically.
Our bias is to suggest that the Yellen will tentatively prepare the market for incremental
rate increases, while talking down the pace and peak. This should prevent sharp
moves in long rates and equities, but continues to underpin the USD, likely
most specifically vs. EUR, AUD and JPY.

Today is a
significant day in the progress of the extension of the Greek loan / bailout /
package (depending on which side of the
negotiation you sit) and, while the ‘list’ of measures that must satisfy
the ‘extension creditors’ missed the deadline, it has now been delivered. The
fact that its receipt is followed by an EU finance minister’s conference call,
rather than a physical meeting, suggests a more procedural than negotiation
stance to its ratification. This leaves us with a four month period where the
real differences between desires of both sides, and perhaps also between the
cost cutting measures "in principle” and
"in practice” come to light.

Prevention is NOT better than Cure!

This does not bode
well for the Eurozone. It may provide time for the region to ‘prepare’ for an
exit for Greece, but it is unlikely to be enough time to for the region to ‘manage’
a solution to the debt woes of Greece. QE, coupled with lower inflation and
energy costs, may provide a near term boost to Eurozone growth. However, it may
also exaggerate the divergences within the region. This morning’s confirmation
of German Q4 GDP growth at 0.7% q/q is a case in point. Regular readers of ours
will know that we continue to highlight Germany’s entrenched competitive advantage
within the Eurozone structure. So, while there were signs in the breakdown of
the German data that some of the gains were due to base effects (and thus the smoothed growth is likely lower
than the data suggests), Germany is likely to benefit proportionally more
than weaker states, particularly if its nascent recovery in domestic demand
continues. Overall, however, the region and the EUR are likely to remain weak.

Elsewhere, further
falls in Oil and other commodities likely put the commodity currency space (AUD, CAD, NZD …) under renewed pressure.
The dominant driver of near term sentiment and direction, however, is likely
Janet Yellen’s impact on US rate expectations and the USD.

"Only
in our dreams are we free. The rest of the time we need wages” Terry
Pratchett

Earlier in the week, we discussed the ongoing poker game
between Greece and the rest of the EU. Yesterday, however, while the game
theory of the two sides continued, market focus returned to what we see as the
ultimate underlying driver of FX in 2015: monetary policy.

First up was the UK. Following on from a strong employment
report, which we will expand on later, the minutes from the Bank of England
Monetary Policy Committee (MPC) meeting at the start of February were broadly
neutral. The MPC voted 9-0 to leave interest rates and asset purchases
unchanged at 0.50% and GBP 375bn respectively. On the inflation front, the
Committee expects that the headline CPI rate is likely to fall below zero in
the first half of this year. However, it also notes that the effects of energy
(and some latent effects of previous moves in GBP) on inflation
dissipate towards the end of 2015 "causing inflation to pick up towards the
target fairly sharply.”

In the UK, the MPC were also clear in their expectations of
wage inflation, where they expect "annual wage growth to recover gradually
towards 4% in 2 years”. We have stressed for many months now that we
maintain a significantly above consensus expectation of wage growth, interest
rates and GBP over the course of 2015, and while the political uncertainty
surrounding the May elections complicates the progression, the BoE view on
consumer prices and wage inflation supports our view.

It is interesting to look at the progression of wages in
the UK. In the last six months of 2014, average weekly wage growth rose around
1 percent. At the same time inflation fell from 1.9% to 0.5%. Taking real wage
growth from -1.2% to +1% in six months. Real wage growth is back at the level
it was before the global financial crisis and, if this dynamic continues to
progress as the BoE expects, then the impact and implications for the consumer,
for GDP and for GBP are significant. We retain our positive view on the UK and
GBP.

"Patience
taken too far is cowardice” Holbrook Jackson

In the US, following a theme which we have noted a number
of times over recent months, the minutes portrayed a more dovish tone than the
policy statement. Essentially, the key issue for US policymakers is, as it is
for UK policymakers, a function of the fact that signs of better (medium
term) growth are offset (in the short term) by weakness in inflation
and geopolitical uncertainty.

The Fed minutes stated clearly that many Fed officials
judge that risks, ranging from a stronger USD to the crisis in Greece, had
inclined them towards keeping rates near zero for "a longer time”. This
outlines the fact that there are differences of opinion, as you would wish and
expect at such an important decision making policy meeting. However, we
continue to expect that economic momentum in the US, driven by job gains (and
likely increasingly wage gains), is strong enough to maintain the positive
economic progress and thus to maintain the removal of what is, in our view, an
increasingly unsustainable level of monetary accommodation.

Ultimately, while there are some cautious views on the Fed,
we continue to anticipate a majority that is hawkish enough to warrant a
removal of the "patience” language in March and a small, yet very
significant rate rise in June.

For the rest of the week, the focus will remain on the
headlines surrounding the Greek negotiations and the situation in Ukraine. The
submission of a letter requesting a six month extension of the bailout from the
Greek government suggests progress. The fact that Eurogroup president Jeroen
Dijsselbloem has called a meeting of Eurozone finance ministers for Friday afternoon
concurs with that sentiment and suggests that some ‘can kicking’ near term
solution to Greece’s immediate liquidity requirements will be found.

The USD may be modestly on the back foot, following the
more dovish tone to the Fed minutes and the resultant lower US rate
expectations and yield curve. However, the jubilation over a deal for
Greece is likely to be short lived and, following the very short term
uncertainty, we expect USD strength to reassert itself.

In 1823, during a
football match at Rugby School, William Webb Ellis caught the ball (which was
allowed at the time) and ran with it (which wasn’t). Accounts of the subsequent
events are unclear. However, it is likely that the other players who had
adhered to the rules of the game for which they had signed up, offered Ellis
the option to play by the rules or go and play his own game.

In Greece, the
invention of sport and athletic competition is part of their history and
heritage. However, at this current juncture, finance minister Varoufakis finds
himself running (ball in hand) while the rest of the EU finance ministers
(particularly those who have endured the pain of adherence to the rules of the eurozone)
protest.

The stand-off is
clear. The Greek government were elected on the basis of renegotiating the
bailout and reversing (at least some) of the austerity, while at the same time
remaining within the Eurozone and the EUR. The rest of the region, having
enforced austerity on the programme countries (as well as some non-programme
countries - all of whom may feel a little aggrieved about easing the terms for
Greece) cannot afford to set a precedent for breaking the rules. Nor can they
allow allow concessions that, if applied to the others, would undoubtedly push
the region’s finances to breaking point (politically at least).

"There is no passion so contagious as that of fear” Michel
de Montaigne

The rise of Podemos
in Spain is a case in point. Any leniency towards the austerity, or debt burden
in Greece, will surely be followed by a populist vote for Spain to follow the
same (confrontational) path following their elections at the end of the year.

There is, however, a
further consideration and it is a point that we have raised before. Mario
Draghi assured the markets that the ECB had in effect ring-fenced the risks
under its QE bond buying programme, through the fact that the national central
banks will buy and hold (80% of) their own debt. The money these purchases
create can flow freely across the region through the Target2 payment system.
Currently within Target2, Germany has claims of around EUR 515bn with all five
bailout countries as well as six others, including France and Spain having
running negative Target2 balances.

Should a nation build
up Target2 liabilities and then leave the union, the remaining member states
would be left with the bill. These balances are therefore a key barometer of
risks building up within the system and the fact that German claims rose to EUR
515bn at the end of January from EUR 461bn in December is a worrying
development.

Policy, Politics and Data

All of this points to
continued uncertainty, heightened risks and, at some point in the future, a
likely fracturing of the Eurozone. While the risks are increasing of a ‘Grexit’,
the most likely scenario is still probably that the Eurozone kick the can
further down the road and agree some (likely political) compromise. At some
point however, as we have stated repeatedly, the road gets too narrow or runs
out entirely!

Ultimately the Greek programme
runs until the end of February, so political wrangling’s will likely continue
to be increasingly dominant for the EUR as we approach that deadline.

In the UK, however, this
week is all about the data with the December employment report and (more
importantly average earnings data) on Wednesday, along with the minutes from
the February BoE meeting, and then public finances and January retail sales in
Friday. We continue to favour GBP outperformance and an earlier rate rise than
currently priced by the market, both of which likely accelerate after the
election in May.

In the US, while
policy is all about the data, the USD is all about policy. Wednesday evening
brings the minutes from the end of January FOMC meeting. Our view remains that
the Fed will maintain their composure and move towards policy normalisation in
June and the January minutes will be a key barometer of this progression.

Inflation, or more
pertinently the lack thereof, has become the dominant driver of financial markets
and global central bank policy alike over past months and quarters. It may seem
obvious to suggest that central bank policy is being driven by (dis)inflation,
when most have a central mandate to target price stability. But, the sharp
decline in energy and food price inflation has distorted the base effects to
the point where traditional relationships may not be as informative as they
once were.

Sweden is an
interesting case in point. Yesterday the Swedish Riksbank unexpectedly cut interest
rates into negative territory and announced plans for a (small) programme of asset purchases. These measures have been
introduced despite growth running at around 2%, and governor Ingves suggesting
that the risks to growth are on the topside. This dovish bias and the explicit
Riksbank aim to utilise the currency as a transmission mechanism suggests the
currency faces significant headwinds.

In the Eurozone, the
monetary bias remains dovish and growth (albeit
showing tentative signs of turning) remains weak, both should remain
headwinds for the currency.

"UK is not experiencing deflation” BoE
Quarterly Inflation Report

In the UK, yesterday
saw the release of the February Quarterly Inflation Report (QIR) which
contained upward revisions to the CPI projections and a more hawkish supporting
rhetoric. The central projection at the 2 year horizon was marked higher to
1.96% and symbolically, inflation at the 3 year horizon projected above target
at 2.15% amid upward revisions to growth.

In the UK (and the US), growth is strong and the
monetary bias is hawkish. We have outlined our view on a number of occasions that
for those countries where there is domestic demand, the "one-off level shift” in inflation (as described by Mark Carney) suggests that the risk to medium term
growth and inflation outlooks are to the topside. We have also highlighted our
view that the markets had become far too dovish on their BoE rate hike
expectations. Those expectations have moved closer over recent weeks,
acknowledged by Mark Carney yesterday in stating "markets did slightly overshoot on rate expectations”.

Market expectations
for the first UK rate hike remain in 2016, however, and we continue to view
this as too far away. The QIR stated that the BoE estimate for the current
level of slack is around 0.5%. This is significantly below the 1 – 1.5% that
was suggested in the middle of last year. If in the past 6 months or so, the
BoE estimates that slack in the economy has declined by 0.5% - 1%, and the Bank
favours raising interest rates before the slack has been eroded entirely, then
it makes little sense for markets to price the first rate hike in around a years’
time.

The uncertainty
surrounding the UK general elections are a headwind for GBP between now and
May. However, provided there is a clear government with a clear plan, then we
would anticipate that UK growth, inflation and even a rate hike will come
sooner than the markets expect, in 2015. GBP may well be a key beneficiary.

"Economy will do better than recently forecast” ECB, Vitor Constancio

In the near term the
combination of lower prices (at least in
regions where there is any domestic demand) and the boost to stability and
confidence from ECB QE (progress in
repairing bank lending channels remains to be seen), mean that a bounce in eurozone
activity is likely. German economic growth in Q4 highlighted that it is not all
bad news in the Eurozone with stronger than expected GDP growth of +0.7% q/q,
driven by strength in consumer activity and business spending, driving the Dax
above 11,000 for the first time.

In fact as we go into
a weekend where there are some signs that Germany and Greece are closer to
common ground on bail out negotiations and the world looks to Russia and Mr
Putin to uphold their end of the Minsk accord, the bias for risk assets,
equities and even the EUR may well be to the upside in the very short term.

However, as the Lithuanian
President, Dalia Grybauskaite, very aptly put it "Greece is not the last problem” for the Eurozone!